Russia’s Sick Economy

The Russian stock market fell another 10 percent Monday, bringing its total drop since January to more than 50 percent. Although the market has since rebounded, many economists suspect that the Russian economy is headed for a deep recession. More pessimistic economists predict that Russia will take the rest of eastern Europe down with it. To head off this scenario, the International Monetary Fund is considering another $670 million in loans to Russia. Why hasn’t Russia’s transition from communism to capitalism been nearly as successful as the transformation of some of the former Soviet satellites? What’s behind the current woes?

When the Soviet government collapsed in the last days of 1991, control of the economy fell to a clique of young economists raised on Chicago School libertarian economics learned from smuggled copies of Western journals. These reformers persuaded Russia’s newly installed President Boris Yeltsin to privatize the state-run economy en masse and to lift all price controls in one fell swoop. The rationale behind this “shock therapy“: If liberals didn’t quickly destroy the Soviet state, Communist Party bosses spouting populist rhetoric would retake power.

From 1991 to 1995, more than 18,000 firms–including 90 percent of the manufacturing sector–were transferred from state to private ownership. Now the state owns only a few major military manufacturers and an oil company, though this will be auctioned off in July. Last year, the private sector generated 70 percent of the country’s gross domestic product. Some question the therapeutic value of this policy of rapid privatization, but none dispute the shock. Since communism, Russia’s GDP and manufacturing have tumbled about 3 percent annually on average (much more in the early years). In 1992, inflation peaked at 1,500 percent and was still as high as 48 percent in 1996.

Last year, however, the economy began to look up, benefiting from Western investors’ enthusiasm for the so-called emerging markets. Russia’s post-communist GDP grew for the first time–a 0.4 percent increase in real terms. Officials at the World Bank and IMF declared Russia had turned the corner. But with the recent tumult, their predictions for Russia’s future have quickly shifted from swim to sink. Here are the most prominent rationales for the new bearishness:

1 Asian collapse. With last fall’s surprising collapse of the Asian economies, Western investors have grown skittish about all “emerging markets.” Though Russia’s economy is not closely intertwined with those of Asia, investors have been shifting to the more stable U.S. markets rather than risking getting burned again.

2. Oil collapse. Russia has failed to develop a competitive post-communist manufacturing sector. Instead, it relies for exports on natural resources, primarily oil. With oil prices plummeting, thanks to new technologies for detecting and extracting oil, Russia is running a trade deficit for the first time since communism’s collapse.

3 No taxes. Despite exorbitantly tax high rates that discourage enterprise, the government brings in ridiculously low revenue. The problem: Nearly everyone bribes tax collectors or simply refuses to pay (of the country’s 150 million people only 4 million filed income declarations last year). With little tax revenue, the government can’t provide even the rudiments of a social safety net or pay its bills. The shortfall also traps the government in a cycle of debt–nearly one-third of its budget is spent servicing its high interest bonds.

4. Credit crunch. Several of the biggest, most corrupt banks collapsed in 1995, drying up important sources of credit. At the same time, the central bank has hiked interest rates continuously to check inflation and allay the fears of Western investors, thus discouraging needed business borrowing. The credit crunch, along with low faith in the stability of the ruble, has fostered bartering in goods and financial assets. Only 10 percent of transactions are currently conducted in rubles–the national currency.

5 Arrears. Labor strikes have multiplied in the post-communist era, especially over the last two years. For the last eight months coal miners in the east, who haven’t received a paycheck for nearly a year, have stopped working and blocked railroads. According to estimates, Russian companies owe their workers nearly $10 billion in back pay. The threat of further strikes and labor disruptions is another deterrent for investors.

6. The ruble. The government worries that foreign investors, anxious to unload their rubles, will force a devaluation of the currency. This would drive up the price of imported goods and reignite the hyperinflation of two years ago. To check this, the central bank has tripled interest rates and used hard currency reserves (now reduced to $10 billion in ready cash) to buy back rubles.

7 Privatization gone awry. Some argue that Russia is still reeling from its misguided plan for privatization. In 1992, the Yeltsin government implemented a program that in essence worked like this: Workers and managers decided the value of their firms and were given the first chance to buy a controlling share in the companies, using government vouchers. The idea of a nation of stockholders is appealing but, in practice, the plants’ old Soviet-style managers gained control. These managers are chided for lacking experience, competence, and the desire to adapt their companies to the market.

Cronyism also undermined the transition. Businessmen used the patronage of politicians to buy companies at fire sale prices. For instance, the government auctioned the Yukos Oil Company for $100 million. A year later, it was valued at $3 billion. The biggest beneficiaries of the patronage have been the seven best-connected magnates–“The Seven Boyars.” Facing little competition, these magnates possess fantastic wealth–mainly from monopolies on natural resources–and own major media outlets. These oligopolies have in most cases proved to be as inefficient and disinclined to innovate as the state-owned monopolies.

8 Yeltsin’s buffoonery. Yeltsin, in failing health, has lost the confidence of foreign investors. Like an old party boss–and he is an old party boss–Yeltsin purges his administration regularly. In March, he dismissed Prime Minister Victor Chernomyrdin and replaced him with a 35-year-old political neophyte, Sergei Kiriyenko. Kiriyenko, however, has drawn praise from Western economists for his commitment to free market economic reform and from the Russian business sector for being friendly to their interests.

9. Organized crime. Organized crime remains rampant, though less widespread than at its mid-’90s peak. Businessmen are no longer routinely assassinated by their competitors. (In 1995, nine out of 30 members of Russia’s Business Roundtable, a chamber of commerce, were knocked off.) The power of the Mafia has been undercut by the oligopolies, each of which has a private army. One of the Seven Boyars employs more than 10,000 security personnel.

10 IMF chicanery. The IMF makes its loans to Yeltsin’s government contingent on the order of Russia’s economic house. Critics, such as Harvard economist Jeffrey Sachs, say that the government’s efforts to satisfy the IMF–by reducing the budget deficit and jacking up interest rates to defend the ruble–have worsened the crisis, deepening the credit crunch and cooling growth. The critics argue that left to itself the market will correct, leaving only a few currency speculators to bear the brunt of a currency collapse. The Clinton administration responds that the risks of a Russian collapse are too high (including the spread of contagion to eastern Europe and Russians resorting to black market sales of nuclear weapons) and failing to provide IMF support would be analogous to canceling insurance while the patient is sick.